The authors of Corporate Governance Matters provide a basis for constructive debate among executives, directors, investors, regulators, and other constituents that have an important stake in the success of corporations. This book focuses on corporate governance from an organizational instead of purely legal perspective, with an emphasis on exploring the relationships between control mechanisms and their impact on mitigating agency costs and improving shareholder and stakeholder outcomes.

This chapter is from the book

Corporate governance has become a well-discussed and controversial topic in both the popular press and business press. Newspapers produce detailed accounts of corporate fraud, accounting scandals, insider trading, excessive compensation, and other perceived organizational failures—many of which culminate in lawsuits, resignations, and bankruptcy. The stories have run the gamut from the shocking and instructive (epitomized by Enron and the elaborate use of special-purpose entities and aggressive accounting to distort its financial condition) to the shocking and outrageous (epitomized by Tyco partially funding a $2.1 million birthday party in 2002 for the wife of Chief Executive Officer [CEO] Dennis Kozlowski that included a vodka-dispensing replica of the statue David). Central to these stories is the assumption that somehow corporate governance is to blame—that is, the system of checks and balances meant to prevent abuse by executives failed (see the following sidebar).1

A Breakdown in Corporate Governance: HealthSouth

Consider HealthSouth Corp., the once high-flying healthcare service provider based in Birmingham, Alabama.2

CEO Richard Scrushy and other corporate officers were accused of overstating earnings by at least $1.4 billion between 1999 and 2002 to meet analyst expectations.3

The CEO was paid a salary of $4.0 million, awarded a cash bonus of $6.5 million, and granted 1.2 million stock options during fiscal 2001, the year before the manipulation was uncovered.4

The CEO sold back 2.5 million shares to the company—94 percent of his total holdings—just weeks before the firm revealed that regulatory changes would significantly hurt earnings, causing the company’s share price to plummet.5

The president and CFO both previously were employed as auditors for Ernst & Young.

The company paid Ernst & Young $2.5 million in consulting and other fees while also paying $1.2 million for auditing services.11

What were the analysts doing?

A UBS analyst had a “strong buy” recommendation on HealthSouth.

UBS earned $7 million in investment banking fees for services provided to the company.12

Perhaps not surprisingly, the CEO also received backdated stock options during his tenure—stock options whose grant dates were retroactively changed to coincide with low points in the company’s stock price (see Figure 1.1).

Interestingly, Scrushy was not convicted of accounting manipulations in a criminal trial brought by the U.S. Justice Department. However, he was ordered to pay $2.9 billion in a civil suit and, separately, was sentenced to seven years in prison for bribing a former Alabama governor.

As the case of HealthSouth illustrates, the system of checks and balances meant to prevent abuse by senior executives does not always function properly. Unfortunately, governance failures are not isolated instances. In recent years, several corporations have collapsed in prominent fashion, including American International Group, Bear Stearns, Countrywide Financial, Enron, Fannie Mae, Freddie Mac, General Motors, Lehman Brothers, MF Global, and WorldCom. This list does not even include the dozens of lesser-known companies that did not make the front page of the Wall Street Journal or Financial Times but whose owners also suffered. Furthermore, this problem is not limited to U.S. corporations. Major international companies such as Olympus, Parmalat, Petrobras, Royal Bank of Scotland, Royal Dutch Shell, Satyam, and Siemens have all been plagued by scandals involving breakdowns of management oversight. Foreign companies listed on U.S. exchanges are as likely to restate their financial results as domestic companies, indicating that governance is a global issue (see the following sidebar).

A Breakdown in International Corporate Governance: Olympus

In October 2011, Michael Woodford was fired as CEO of Olympus Corporation of Japan, after only two weeks in the position. Woodford uncovered evidence of fraud while investigating the legitimacy of a $687 million “advisory fee” made in association with a recent acquisition. When he confronted the board of directors, he was dismissed and replaced by former CEO Tsuyoshi Kikukawa. An independent investigation eventually exposed the details of a massive, long-running scheme to hide more than $1.5 billion in investment losses dating back to the 1980s.13 Members of the board, current and former executives, auditors, and bankers were implicated. Kikukawa was arrested and sentenced to three years in prison.

Self-Interested Executives

What is the root cause of these failures? Reports suggest that these companies suffered from a “breakdown in corporate governance.” What does that mean? What is corporate governance, and what is it expected to prevent?

In theory, the need for corporate governance rests on the idea that when separation exists between the ownership of a company and its management, self-interested executives have the opportunity to take actions that benefit themselves, with shareholders and stakeholders bearing the cost of these actions.14 This scenario is typically referred to as the agency problem, with the costs resulting from this problem described as agency costs. Executives make investment, financing, and operating decisions that better themselves at the expense of other parties related to the firm.15 To lessen agency costs, some type of control or monitoring system is put in place in the organization. That system of checks and balances is called corporate governance.

Behavioral psychology and other social sciences have provided evidence that individuals are self-interested. In The Economic Approach to Human Behavior, Gary Becker (1976) applies a theory of “rational self-interest” to economics to explain human tendencies, including one to commit crime or fraud.16 He demonstrates that, in a wide variety of settings, individuals can take actions to benefit themselves without detection and, therefore, avoid the cost of punishment. Control mechanisms are put in place in society to deter such behavior by increasing the probability of detection and shifting the risk–reward balance so that the expected payoff from crime is decreased.

Before we rely on this theory too heavily, it is important to highlight that individuals are not always uniformly and completely self-interested. Many people exhibit self-restraint on moral grounds that have little to do with economic rewards. Not all employees who are unobserved in front of an open cash box will steal from it, and not all executives knowingly make decisions that better themselves at the expense of shareholders. This is known as moral salience, the knowledge that certain actions are inherently wrong even if they are undetected and left unpunished. Individuals exhibit varying degrees of moral salience, depending on their personality, religious convictions, and personal and financial circumstances. Moral salience also depends on the company involved, the country of business, and the cultural norms.17

The need for a governance control mechanism to discourage costly, self-interested behavior therefore depends on the size of the potential agency costs, the ability of the control mechanism to mitigate agency costs, and the cost of implementing the control mechanism (see the following sidebar).

Evidence of Self-Interested Behavior

How prevalent are agency problems? Are they outlier events or an epidemic affecting the broad population? How severe are agency costs? Are they chronic and frictional or terminal and catastrophic?

To gain some insight into these questions, it is useful to consider the frequency of negative corporate events that, in whole or in part, are correlated with agency problems. However, before looking at the statistics, we also need to highlight that not all bad outcomes are caused by self-seeking behavior. A bad outcome might well occur even though the managerial decision was appropriate (that is, other management might have made the same decision when provided with the same information). With that important caveat, consider the following descriptive statistics:

Bankruptcy—Between 2004 and 2013, 1,118 publicly traded companies filed for Chapter 11 bankruptcy protection in the United States.18 Of these, approximately 10 percent were subject to a Securities and Exchange Commission (SEC) enforcement action for violating SEC or federal rules, implying that some form of fraud played a part in the bankruptcy.19 Bankruptcies linked to fraud are a severe case of agency problems, usually resulting in a complete loss of capital for shareholders and a significant loss for creditors.

Financial restatement—Between 2005 and 2012, publicly traded companies in the United States issued 8,657 financial restatements. Although some financial restatements result from honest procedural errors in applying accounting standards, financial restatements also can occur when senior management manipulates reported earnings for personal gain. According to the Center for Audit Quality, approximately half of the restatements announced during this period were “serious,” meaning that the company’s previously published financial reports were no longer reliable.20

Class action lawsuits—Between 2004 and 2013, almost 200 class action lawsuits were filed annually against corporate officers and directors for securities fraud. No doubt some of this litigation was frivolous. However, market capitalization losses for defendant firms totaled approximately $110 billion each year (measured as the change in market capitalization during the class period). This somewhat crude approximation averages $640 million per company (see Figure 1.2).

Foreign Corrupt Practices Act violations—The Foreign Corrupt Practices Act (FCPA) of 1977 makes it illegal for a company to offer payments to foreign officials for the purpose of obtaining or retaining business, to fail to keep accurate records of transactions, or to fail to maintain effective controls to detect potential violations of the FCPA. Between 2004 and 2013, the SEC and the U.S. Department of Justice filed approximately 30 enforcement actions per year against U.S. listed corporations for alleged FCPA violations. Notably, this figure has trended upward. Violations are settled through a disgorgement of profits and other penalties. In 2013, the average settlement amount came to $80 million per violation.21

“Massaging” earnings—Senior executives are under considerable pressure from the investment community to forecast future earnings and then to deliver on those targets. In a survey of senior financial executives, Graham, Harvey, and Rajgopal (2006) found that a majority are willing to massage the company’s earnings to meet quarterly forecasts.22 For example, 55 percent state that they would delay starting a new project, even if the project is expected to create long-term value. Separately, respondents were given a scenario in which initiating a new project would cause earnings per share in the current quarter to come in $0.10 lower. The respondents reported an 80 percent probability that they would accept the project if doing so enabled them to still meet their earnings target but only a 60 percent probability if the project caused them to miss their earnings target.

These statistics suggest that agency problems caused by self-interested executives are likely to be quite prevalent, and the cost of managerial self-interest can be substantial. Dyck, Morse, and Zingales (2013) estimate a 14.5 percent probability that an average company engages in fraud in a given year and that, when uncovered, fraud costs investors 22 percent of the firm’s enterprise value.23

Certain behavior attributes are known by the Association of Certified Fraud Examiners to be “red flags” displayed by fraudulent agents. These include living beyond one’s means (44 percent of fraud cases), financial difficulties (33 percent), unusually close association with vendors (22 percent), control issues and a lack of willingness to share duties (21 percent), a “wheeler dealer” attitude (18 percent), divorce or family problems (17 percent), irritability or suspiciousness (15 percent), and addiction problems (12 percent). Other red flags include complaints about inadequate pay; previous employment problems; refusal to take vacations; excessive organizational pressure; social isolation; and other financial, legal, or personal stresses.24